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Credit hedge funds?

Credit volatility has been dormant for many years but I doubt for much longer. The financial industry has benefited greatly from too easy credit. Funding costs have been advantageous allowing for cheaper exploitation of market anomalies. With bond yields so low there was inevitable demand for higher performing products. Some popular alternative investment strategies will not perform well WHEN we enter a period of turbulence. In particular when real estate sneezes, credit markets catch pneumonia.

There's a good number of CDO, CLO and CPDO structurers, credit derivatives traders, private equity gurus, overleveraged real estate speculators and benign credit dependent funds marketing themselves as "absolute return" that have little experience of such conditions. Funding and leverage has been cheap for a long time. The infamous yen carry trade made borrowing almost free for those ignorant of the high risk. Many borrowed liquid short term to invest in illiquid long term structured products. They will get their real education soon.

It is ages since we had genuine market volatility. The last time we had real US interest rate uncertainty was 1994, a year in which several "hedge funds" were revealed as having been previously lucky. The search for yield has reduced credit spreads enormously yet such spreads will not do well when turbulence returns. Private equity and real estate are very dependent on steady credit and mortgage costs. Their hidden correlation to public equity is horrendous. Not alternatives at all.

Hedge fund performance is not indexed to inflation. In the 1980s many risk free rates round the world were in double figures. Hedge funds in those days HAD to produce much higher returns to be worth investing in. A few strategies benefit from rising rates; for example managed futures and short biased funds have large cash balances. Put option prices drop as rates rise so those hedging costs reduce. But some hedge fund strategies are negatively exposed to rising rates, costly credit, steeper yield curve twists and lower interest rate differentials between currencies.

A lot of time is spent on the alpha versus beta debate but little consideration is given to another equally important but often ignored greek letter - rho, the sensitivity to changes in interest rates. Some hedge fund strategies have negative rho, that is depend on interest rates staying low. Ironically pension funds have positive rho as rising rates permit them to use a higher number to discount future liabilities. That can be a pyrrhic victory because on the asset side of the balance sheet their portfolios of stocks and bonds tend to fall in such times. It therefore makes sense for investors to diversify with OTHER strategies that tend to perform well in a RISING interest rate environment.

Some fund of hedge funds target a relative return like LIBOR + 500bp and not an absolute return. This is an attempt to look "institutional" but ignores what risk free means. LIBOR is not risk free. In Japan that hurdle implies an easy 5% a year while in Iceland that means a much tougher 20% hurdle. Surely an absolute return strategy necessitates an absolute return target. It is not as though hedge fund returns will magically ratchet up if rates rise. It would be better to aim for an absolute 10% depending on the risk profile than some relative benchmark. Some "market neutral" hedge funds tout their alleged dollar, market cap, beta and delta neutrality but are not rho neutral.

Hedge fund performance measures also have negative rho. The Sharpe, Sortino and Information ratios change significantly depending on what risk free rate is selected. All go lower as the risk free rate in the numerator rises. Yield curves are pretty flat but choosing the lowest point on the curve makes a significant difference. The same hedge fund performance will have very different reward to risk ratios depending on the rate and base currency. In the early 1980s there were some very good hedge funds around with "poor" Sharpe ratios because risk free rates were in the high teens.

Negative rho can be as dangerous as negative gamma but many investors don't realise how short rho they are in their total portfolios. Rho sensitivity has been ignored for a long time by many market participants. Many countries are already in the process of renewed inflation. Stress tests for credit sensitivity are always necessary. The BEST hedge funds do this but NOT all who claim to be hedge funds.

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